The Impact of Misaligned Incentives
It’s a free piece, and I strongly recommend reading it in full. Love Mike’s content beyond belief.
Misaligned incentives are the ones that allow, encourage and reward decision making leading to long-term value destruction / erosion.
Example 1: tying up exec comp to the EPS (earnings per share) encourages M&A to grow EPS at the potential (and likely) cost to the business in terms of long-term value.
Example 2: not tying the exec comp to the company’s financial metrics / goals, allowing the execs to receive their incentives even if the company doesn’t achieve their publicly stated “North Star” goals, reduces the power of the Board to challenge the management.
Please also read the “Dark Arts” piece that Mike wrote and I summarized.
Some things the Boards should look into and make their judgement on whether to start investigations are: the choice of metrics to judge the management against (and who chooses them); the lack of Return on Capital metrics (or, as INSEAD suggests, the ROIC metric); not tying a part of the overall comp to the execution of the multi-year (3-5) operating plan; the constant adjustment of the targets by the Comp Committee (at the request of the management).
Not all misaligned incentives lead to value destruction, and execs can (and often do) show stellar behaviour regardless of what they’re judged on. But since it’s not hard to twist the incentives towards benefitting the insiders, the Boards (or even the activist investors) should (unfortunately) be more paranoid than the common courtesy suggests.
Setting comp targets by Boards (especially – independent) are not an easy task. Board members can be influenced (either by not being truly independent or by the virtue of laziness) or mildly corrupt (i.e. putting their interests like comp and tenure ahead of their constituents’ interests). Incentives and outcomes can easily decouple.
It shouldn’t come as a surprise that execs want to be compensated no matter what, so it’s completely normal to expect them to downplay negative events. And – not to blame the execs alone – investors may insist on things (via the comp) that are not healthy for the long-term value creation of the company, too. After all, they’re outsiders.
Misaligned incentives are like technical debt – it’s inevitably going to happen, and the goal is to neutralize it, not to eliminate it.
Shareholders should be on a lookout for such incentives, because the management’s capturing the upside and being insulated from the effects of the downside can go on unchecked for years. At the very least, there must be the urgency to make changes.
Example 3: the execs are looking to hit the low end of the investment guidance after chasing the top end in the past. It’s usually the sign of trouble, albeit not immediately obvious. There are two ways of getting the top bonus: hitting the top target or moving the goalpost down. If it’s the latter – something must be going on. And especially – when the company underperforms compared to the peer group, but the execs are getting the top bonuses.
The market applies the “misaligned incentive discount” if it becomes clear that the tail is wagging the dog. The Board stepping up and updating the comp structure can remove this discount. Alternatively, there’s no shortage of activist investors looking to shake things up and uncover the true value in the process.
The more complex the comp structure – the more there’s to gain for the insiders. Complex structures are easier to manipulate.